Chapter 8: Economics of Strategy: Creating and Capturing...

Managerial Economics and Organizational Architecture, 5e

Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

Managerial Economics and Organizational

Architecture, 5e

Chapter 8: Economics

of Strategy: Creating and

Capturing Value

McGraw-Hill/Irwin


Strategy

• General policies intended to generate

profits

– Choice of industry

– Combination of products and services

– Competitive and cooperative behaviors

• Strategies evolve as circumstances

change

• Strategies must create and capture value

8-2


Transaction Costs

• Consumer transaction costs

– product search

– learning product characteristics and quality

– negotiating terms of sale

– enforcing agreements

• Producer transaction costs

– negotiating terms

– legal expenses

8-3


Ways to Create Value reduction of transaction costs

Price

(in

do

llars

)

Quantity

Consumer surplus

Producer surplus

Effective supply given

transaction costs

Potential supply if no

Transaction costs

Potential demand if no

Transaction costs

Effective demand after

Transaction costs

Q

8-4


Value Creation

• Reduce production costs or producer transaction costs

– shift supply curve to the right

• Reduce consumer transaction costs

– shift demand curve to the right

• Shift demand to the right by other means

• Devise new products and services

8-5


Other Ways to Increase Demand

• Improve product quality

• Price complements so consumers will buy more

– printers and ink cartridges, razors and razor blades

• Change the price of substitutes

– Theaters ban patrons from bringing food into the theater, no liquids are allowed past the security gates at airports

8-6


Pricing Complements Example

• CompuInc produces computers

• PrintCo produces complementary printers

• Demand for each product is

• Q=12-(Pc+Pp) when (Pc+Pp)12, 0 otherwise Profit-maximization yields reaction curves

Q)P(P ji 12

ji P.P 56

• Each will view its demand curve as

8-7


Noncooperative Pricing

CompuInc & PrintCo

P

rice

of P

rin

tCo

prin

ters

Price of personal computers

Compulnc’s reaction curve

in choosing PC

PrintCo’s reaction curve

in choosing Pp

6

6 12

Pp

Pc Pc = 4

Pp = 4

12

8-8


Advantage of Coordination

• Failure to coordinate yields combined

profits of 32

• Jointly setting MC = MR yields combined

profits of 36

– customers better off as product prices fall,

quantity purchased rises

8-9


Converting Organizational

Knowledge into Value

• Hardware – physical assets

• Wetware – employee brainpower

• Software – formulas or recipes for creating

value

• Implications - allow employees to

experiment and innovate

8-10


Capturing Value

• Firms in competitive markets are price

takers

• Firms with market power choose price and

quantity

– They can capture value if they exploit their

market power

8-11


Market Power Comparison

Producer surplus S

D

$ $ $

Price (

in d

olla

rs)

Di

P* Dj

Qi Qj Q

Q*

Quantity: Firmi Quantity: Firmj Quantity: Industry

P*

MARKET POWER COMPETITIVE INDUSTRY

8-12


Market Power Rests In

• Entry barriers

– Economies of scale, patents, brand names, high exit costs

• Degree of rivalry

– Number and size of competitors

• Threat of substitutes

– Outside products (satellite dish vs. cable)

• Buyer and supplier power

– Number and size matters 8-13


Other Value-Enhancing Strategies

• Introduce new products and services

• Cooperation with other firms

8-14


Superior Factors of Production

• People

– special talents or skills

• Physical assets

– prime real estate

– unique equipment

8-15



• Bidding for specialized assets may erode

profits

• If a resource is adding value to a firm,

other firms will attempt to bid this resource

away

• The price of this resource will rise, raising

costs

• Initial profits will fall 8-16




profits



away


costs



Producer Surplus Captured by

Superior Assets

Co

st p

er

un

it (

in d

olla

rs)

P*1

P*0

Q*0 Q*1

Quantity: Firm i

LRMC

LRAC1

LRAC0

Qi

$ $

Quantity: Market

Q*0 Q*1

D0

Q

D1

S

8-20



• Team production

– interdependencies among workers increase

value beyond the “sum of the parts”

– luck or foresight may endow firms with unique

team production capabilities

• Rivals may be unable to pinpoint source of

advantage and unable to capture

equivalent value

8-21


Diversification

• Benefits

– Economies of scope

– Promoting complements

• Costs

– Bureaucracy

– Incompatible cultures

8-22


Diversification and Management

• Diversification for earnings volatility

– may not increase value

• Investors can diversify on their own

• Related diversification

– can increase value

• Capturing the gains

– Target firms often obtain the largest gains in a

takeover

8-23


Strategy Formulation

• Understanding internal resources and capabilities

– physical, human, and organizational capital

• Understanding the environment

– markets, technology, and government regulation

• Combining environmental and internal analyses

• Strategy and organizational architecture

8-24


Framework for Strategic Planning

STRATEGY

INTERNAL RESOURCES

AND CAPABILITIES

Physical Capital

Human Capital

Organizational Capital

BUSINESS ENVIRONMENT

Markets

•Input

•Output

Technology

•Production

•Information

•Communication

Government Regulation

8-25


Capturing Value

• Can a firm capture value on a sustained

basis?

• Market will bid prices of resources up

• Environments change

• Normal rates of return will be earned in the

long run

8-26

Chapter 8: Economics of Strategy: Creating and Capturing...

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